2.1 An Overview of Levels of Regulatory Framework

The details of the regulatory framework of accounting and the techniques for dealing with accounting information will be covered later in your further studies. The objective of this section is to give an overview of some of the rules, regulation bodies, authorities and other factors that may bring changes to financial accounting. An overall picture of the applicable factors is shown in Exhibit 2.1.

2.1.1 National/Local Legislation

In most countries, limited liability companies are required by law to prepare and publish annual financial reports. The form and content of these reports are regulated primarily by national legislation. A listed company can get its shares traded on a stock exchange, e.g.the London Stock Exchange, or the New York Stock Exchange. Unlisted companies tend to be smaller than listed companies and their shares cannot be traded on a stock exchange. Countries may have different laws regulating these two types of companies, but normally not in detailed guidelines.

Multinational organisations, whose branches are located in different countries, must make sure each branch complies with all the legislation rules of local countries in preparing financial reports and doing tax returns, although another version of reports should usually be produced in the same way as their headquarter requires.

2.1.2 Accounting Concepts

A number of accounting concepts have been applied ever since financial statements were first produced for external reporting purposes. These have become second nature to accountants and although not generally reinforced, they are commonly accepted by entities through customs and practices. An accounting concept is an assumption that forms the basis of the preparation of the financial statements of the organisation. These are accounting procedures that have developed over the years to form the “basic rules of accounting”. In IASB's Conceptual Framework, which will be illustrated in Chapter 3, some accounting concepts are emphasised as the underlying assumptions and the qualitative characteristics of accounting information. The following are the rest, which are also generally accepted as a common sense, even though not listed as that important in the Conceptual Framework.

1.Historical Cost Concept

A historical cost is a method of accounting valuation in which the value of an asset on the SOFP is recorded at its original cost when acquired by the company. The historical cost method is used for most non-current assets and current assets because the transaction cost is more objective, verifiable and reliable than other valuation methods. It has been widely criticised for being out of date and irrelevant for users to make economic decisions. Assets tend to be undervalued by historical cost, especially for properties, such as land and buildings which have rising prices all the time.

For example, a property was purchased 10 years ago at a cost of $10,000. Now, the current market value of it may have soared all the way to $100,000 if it is for sale on the market. However, since it is still held in possession of the entity, on its SOFP, the property would have a carrying value of even less than its original cost due to depreciation. The asset of the entity is severely undervalued. Nowadays,fair value has been adopted as a making up method for its deficiency, and the call for current value accounting (CVA) is growing.However, historical cost accounting still occupies the most important position in asset valuation.

2.Stability of Currency Concept

The stability of currency concept means that since accounting follows the historical cost concept, assets are normally shown at their original cost. This has the effect of distorting the financial statements if inflation has caused the value of money to change over time-assets purchased 20 years ago for $50,000 would cost considerably more today, yet they would appear at that cost, not at the equivalent cost today. Users of financial statements need to be aware of this.

3.Business Entity Concept

The business entity concept implies that the affairs of a business are to be treated as being quite separate from the non-business activities ofits owner (s). Despite of the inseparable legal entity requirements for sole traders and partnerships, only the transactions of the business are recorded and reported in the financial statements. Any transactions involving the owner (s) are kept separate and are excluded. The only time that the personal resources of the owner (s) affect the accounting records of a business is when they introduce new capital into the business, or take drawings out of it.

For example, if the owner starts a sole trading business by transferring $20,000 cash from his personal bank account into the business's bank account, the business's cash account increases because cash has been put into it. As learners in the preliminary stage as you are, it is often taken for granted that the cash decreases, as cash is taken out of the owner's personal bank account. It is a confusion of business entity concept to mistakenly consider the owner is the business.

4.Monetary Measurement Concept

From the start, accounting information has been only concerned with the facts that:

●It can be measured in monetary units;

●Most people will agree to the monetary value of the transaction.

This restriction is called the monetary measurement concept, and it means that financial statements cannot show everything we want to know about a business.

For example, accounting does not show the following:

●Whether the business managers have good expertise in the field they are managing;

●Whether the business has serious problems with the workforce;

●Whether the business has many loyal customers.

The reason that the above or similar items are not recorded is that it would be impossible to work out their monetary value that most people would agree to. This is also the reason why accounting is always criticised. The notes and other reports in companies’ financial reports are supplements to financial statements, in order to show other quantitative and qualitative information which are not in monetary forms.

5.Duality Concept

The duality concept states that there are two aspects of accounting, one represented by the assets of the business and the other by the claims against them. The concept states that these two aspects are always equal to each other. In other words, this is the alternate form of the accounting equation:

The duality concept is the fundamental principle of double-entry system of accounting, which means every financial transaction has equal and opposite effects in at least two different accounts. This principle will be illustrated in detail in Chapter 5.

6.Time Interval Concept

The time interval concept states that financial statements are prepared at regular intervals, though the business activities are continuous. The most normal interval is one year, and companies are required to prepare annual financial statements according to financial year requirements by their countries.

For example, for companies in most countries e.g. China, the natural calendar year from January to December is also the accounting year; In some countries e.g. the UK, Canada and Japan, the accounting year starts from April to the next March; In countries like Australia and Sweden, from July to the next June is adopted as the accounting year; While in the US, it is from October to the next September. Other countries may have various accounting years from March to next February, November to next October.

Even with the accounting year settled as above, companies in some countries can also choose their own accounting year end to publish their financial reports. The distinction has been caused by many reasons of political, economic and cultural aspects. One of the reasons why the calendar year is not adopted in some countries is because at the end of the calendar year, all kinds of affairs come to an end and accounting work intensively occupies a large amount of resources of all the society. This may cause inefficiency and stagnation in economic activities. It can be alleviated to some extent by adopting flexible accounting year.

Companies that publish further financial statements between their annual ones describe the others as “interim statements”. For listed companies, most countries would require quarterly financial reports to be published as well as annual financial reports. While, for internal management purposes, financial statements may be prepared far more frequently, possibly on a monthly basis or even more often.

7.Realisation Concept

The realisation concept states that realisation occurs only when the ultimate cash realised is capable of being determined with reasonable certainty. Only after realisation has occurred, profit and gains can be accounted for in financial statements. The following conditions must be satisfied to make sure realisation occurs:

●goods or services have been provided for the customer;

●the customer accepts the liability to pay for the goods or services;

●the monetary value of the goods or services has been ascertained;

●the customer is going to be able to pay for the goods or services.

For example, an entity recognises a sales revenue when goods are delivered to the customer together with an invoice showing the exact amount to be paid and the expected due date. Neither can the entity account for the sales revenue when the order is received from the customers, nor should it wait until the customer has paid up the bill. However, if the sale is on sale or return basis, the entity must make sure the right for return has expired before accounting for the sales revenue, because only until then, it is virtually certain that the customer accepts the goods and the liability to pay.

2.1.3 The GAAP

The GAAP is the abbreviation for Generally Accepted Accounting Principle (Practice), It refers to all the rules, from whatever source, which govern accounting in various industries. It covers all the accounting concepts, assumptions, and more specifically, the recognition, measurement requirements, as well as presentation and disclosure procedures in detail.

GAAP is a collective name for rules from two broad aspects, one is national/local/regional and the other is international.

The national/local/regional aspect normally refers to the applicable accounting standards for the country or regional area. For instance, the accounting standards in the US are called US GAAP, in China, called PRC GAAP, and in the UK, UK GAAP, etc. They are a set of specific rules giving directions to accounting treatment of events and transactions.

International GAAP normally refers to the International Financial Reporting Standards (IFRSs) which are developed and published by IASB. The main objectives of the IFRS Foundation are to raise the standard of financial reporting and eventually bring about global harmonisation of accounting standards. It is not reinforceable in any country, but countries tend to take account of the international influences of IFRSs and reflect the changes when they revise their own standards.

Since this series of textbooks is IFRSs-oriented, detailed requirements on how to recognise, measure, present and disclose accounting events or transactions will be covered gradually in your study.

2.1.4 Individual Judgements and Other International Influences

Even with the regulations from the levels of legislation, accounting concepts and more specified national GAAPs, it is still very common that different people exercising the rules by adding their own judgement on the same facts can arrive at very different results on financial statements.

Examples where there are variable judgements for different people are as the following:

●For a van newly purchased, is it more reasonable to estimate its useful life as ten years or fifteen years? And what will be the scrap value which can be realised when it is sold at the end?

●What is the valuation of the building which was bought several years ago and the property price has been falling since then?

●What is the likelihood for the business to fail in a lawsuit and what is the probability for paying the penalty of different amount?

●How much out of the total receivables at the year-end is never going to be paid by customers?

All these questions are crucial to be addressed before accounting entries can be made, and different accountants may have different answers to each of them. We cannot always find directions to accounting entries in the accounting standards because as principle-based as IFRSs are, the instructions are not like a cookbook style as the rules-based standards. What the accountants can do is to use their own professional judgements, to prepare the financial statements as truly and fairly as possible. As long as the treatments are verifiable and justifiable, it is acceptable, even though there are still differences in the results at the end, for example, they may lead to different profits and SOFPs which have different figures under each item. This can inevitably give the management opportunities for profit manipulation and “window dressing” their financial statements. It is the external auditors’ main task to evaluate whether the accounting treatments are acceptable or not.

Other international influences, like EU Derivatives, have effects on its member countries’ standard-setting and accounting treatment for certain items.